Call it the mystery of the missing bond-fund assets. Nobody knows exactly how much has vanished, but the number is in the billions. To be sure, the fund managers haven't run away with the money. However, try telling that to shareholders who have seen the net asset value of their fund shrink over the years.
The puzzle: Interest rates today are about the same as they were eight years ago. And since the value of a bond remains the same if rates are unchanged, a bond mutual fund's principal, or net asset value, should be little changed as well. Then why have the NAVs of bond funds dropped 7.6% during this period (table)? What's worse, some large funds dropped in excess of 15% without taking any hits in derivatives or other exotic investments.
The clue: Over the years, many bond funds paid out interest income that seemed well in excess of the going rate in the bond market.
The solution: These funds were pursuing an investment strategy that paid out a higher current yield at the expense of the fund's capital. So at the end of the period, NAVs had suffered a large decline. Such losses have not gone unnoticed by the fund managers, especially as investors are yanking billions out of bond funds this year. The managers are taking steps to change past practices, hoping to restore investor confidence in their products.
GOOD BUY? Funds were able to hype their yields by investing in what is called "premium" bonds--bonds that were issued when interest rates were very high and now sell way above par. Take the Treasury bond maturing in February, 2015, with an 11.25% coupon, which pays $112.50 a year in interest. That's about three percentage points higher than the current rate. Of course, you can't expect to pay only $1,000 for that plum return. In fact, that bond is trading at 129.44, or $1,294, even though its face value is just $1,000.
Even so, it looks like this bond is a real buy, because the current yield is 8.7% ($112.50 divided by $1,294). But here's the rub: Each year, the value of that bond declines as it gets closer to maturity. By 2015, it will be redeemed at just $1,000. So the yield to maturity is in fact much closer to 8%--the current rate in the market.
But premium bonds were just what many bond funds were looking for to perform their sleight-of-hand. Because the current yield was higher, the fund was able to pay out more income even as the NAV was melting away.
For sure, this high-yield strategy doesn't mean the funds lost money for their shareholders. What's most important to mutual-fund investing is total return--the yield plus any changes in net asset value. And some of the funds that have suffered major losses in NAV, such as the Lord Abbett U.S. Government Securities Fund (down 17.9% during that eight-year period), have delivered good total returns because of their high payouts. In total return, the Lord Abbett fund ranked No.1 among comparable funds for the 10 years ending Sept. 30, according to Morningstar Inc., the fund data service. That, says portfolio manager Robert S. Dlw, validates the high-yield strategy. "Get the total return right, and everything else falls into place," says Dow.
Not everything. Investors could be hit with higher tax bills. That's because they receive higher current interest income on which they pay taxes and build in long-term capital losses. It's hardly a tax-wise strategy. That higher income is taxable when it's paid out. (Unless, of course, it's deferred under a qualified retirement program.) Capital losses have value, too, but not until the fund is sold, and that could be years away.
The emphasis on income is simple to explain: Yield sells. It's no accident that the funds that have done the poorest job of preserving NAV were load funds sold through brokers and financial planners. "The expertise of some selling agents is talking about yield and nothing more," says Barry P. Barbash, director of the Division of Investment Management at the Securities & Exchange Commission. Load funds also emphasize income because they often need it to pay the brokers' fees. No-load funds, which are bought by investors and not sold by salesmen, have done a much better job of preserving capital, according to John Rekenthaler, editor of Morningstar Mutual Funds, which conducted the study of NAV erosion.
It's tough for investors to pierce the bond-fund prospectuses and financial statements to learn if yield is eating into the NAV. Investment policy statements can be vague, and funds often say they attempt to preserve capital when their actions suggest otherwise. "Even if the information is disclosed, is it disclosed in a way the investor is going to understand?" asks the SEC's Barbash.
HARDER TASK. Some fund companies are changing their ways. Portfolio managers at Putnam, SunAmerica, and Transamerica say they've reduced their monthly income distributions rather than pay out higher returns that could result in NAV loss. Putnam's Michael Martino says his four funds have switched to a flexible distribution policy--keeping the monthly payout as close as possible to the bond market's current rate of return. "Government funds have always tried to maintain a consistent payout," says Warren F. Schmalenberger, director of fixed-income at Transamerica Fund Management Co. "That's going to change."
Some fund-watchers believe it will get tougher for funds to pay high yields. Allen Goldstein, a national director for mutual-funds services at Price Waterhouse, says changes in tax and accounting rules will make taxable bond funds adopt more realistic payouts. Taxable funds might start operating more like muni funds, which must amortize bond premium and deduct it from income, not from capital. Muni funds, notes Morningstar's Rekenthaler, have not suffered the large NAV losses that plagued taxable funds.
To be sure, many fund companies will be paying more attention to capital preservation in the future. But investors still have to cast a critical eye on bond funds that promise high yields. The extra cash a fund might be putting in one pocket might have been deftly picked out of another one.
The Big Shrink In Bond-Fund Asset Values What would have happened to your principal if invested in a government or investment-grade bond fund on Nov. 1, 1986, when interest rates were roughly the same as they were at the end of the third quarter of 1994? You might think your principal-net asset value in mutual fund terms-should be about what it was in 1986. But for many large funds, it's actually a good deal lower-in excess of a 15% decline. FUND* CHANGE IN NET ASSET VALUE (%) Nov. 1, 1986 - Sept. 30, 1994 THOMSON INCOME B -26.6 MAINSTAY GOVERNMENT -20.8 KEMPER U.S. MORTGAGE B -20.5 TRANSAMERICA U.S. GOVERNMENT A -19.0 PILGRIM GNMA -18.3 PUTNAM AMERICAN GOVERNMENT INCOME -18.2 LORD ABBETT U.S. GOVERNMENT SECURITIES -17.9 SUNAMERICA U.S. GOVERNMENT SECURITIES -17.8 TRANSAMERICA GOVERNMENT SECURITIES A -17.8 DEAN WITTER U.S. GOVERNMENT SECURITIES -17.6 ALLIANCE BOND U.S. GOVERNMENT A -17.3 THOMSON U.S. GOVERNMENT B -17.3 KEYSTONE CUSTODIAN B-1 -16.8 PUTNAM U.S. GOVERNMENT INCOME -15.7 AVERAGE OF 181 FUNDS -7.6 *Excludes short-term and zero-coupon bond funds DATA: MORNINGSTAR INC.